Rumors have been spreading across trading floors that the Fed may lower the penalty for using its dollar liquidity swap line to reduce stress in the interbank market. As I mentioned in a previous note, a 100bp ‘penalty’ over the overnight indexed swap (OIS) rate for the Fed’s dollar liquidity swap line is preventing the tool from impacting interbank borrowing risks as LIBOR continues to climb. The OIS rate currently stands at 0.22%, which means anyone utilizing the Fed’s swap program would be paying 1.22%, well above the current 3M USD LIBOR rate of 0.54%, leading to the programs ineffectiveness. In fact, the ECB’s most recent offering for the program on May 19th lacked even a single taker. If market speculation pans out and the Fed reduces the penalty spread to 50bps from 100bps, then the borrowing cost would fall to 0.72%–below the Fed’s discount rate of 0.75%–, but still remain well above current LIBOR levels meaning the impact could be minimal.

After stabilizing from 5/20 to 5/24 AUDJPY’s decline has returned with a vengeance falling to 72.88 from 74.63 a day prior. The currency pairs stability over the last few days led some to believe the market could be approaching a bottom. Other notable risk indicators moving this morning include the TED spread, now up to 38.6bps (from 18.6 at the beginning of the month), and US breakeven rates. 1Y breakeven rates fell below zero this morning, with rates on the long end of the curve beginning to see more significant declines. Investors in Europe continue to flock to the safety of Germany with German 10Y yields reaching a record low 2.56%. Other than a quick peaceful resolution to the geopolitical risks building in the Korean peninsula, there doesn’t appear to be any near-term positive catalysts in the pipeline to shift investors sentiment.

Global markets may be converging on a new ‘volatile’ norm as investors revalue risk, as governments begin the painful process of deleveraging to more sustainable debt levels. Thus far fears of sovereign defaults have remained contained to the usual suspects—fundamentally weak nations—leading investors to flock to the safe-havens of the U.S., Japan, and Germany. Risk aversion has pushed 10Y German Bund yields down to a multi-decade low of 2.632%; while 10Y U.S. Treasuries are yielding 3.113% from nearly 4% in April. Yet, safe-haven debt levels are in most cases worse than their weak counterparts, especially in the case of Japan, meaning deleveraging is a unilateral prescription. I won’t beat a dead horse on who could be the next Greece, but I do want to emphasize that deleveraging is a painful process, which can adversely impact growth. Eventually, in the U.S. tough austerity measures coupled with substantial tax increments will be necessary, transforming the fuel of the nascent economic recovery, fiscal stimulus, into fiscal drag. Japan’s likely the most at risk of the safe-havens with a vast amount of its debt financed domestically, by what is now a shrinking and ageing population; meaning external financing will ultimately be necessary. This could cause investors to reassess Japan’s stability. The good news is while tough measures in the US are necessary— creating significant economic headwinds— it should allow the nation to avoid the fate of Greece. Meanwhile, I recommend monitoring investor sentiment toward Japan as the canary in the coal mine for the U.S.

SNB Vice Chairman Thomas Jordan said earlier today that the central bank has “countered” pressure on the franc during the financial crisis. “During the financial crisis, there has been much pressure on the Swiss franc which appreciated,” Jordan said in Wettingen, Switzerland. “The SNB has countered that pressure so that until now we haven’t seen an excessive appreciation of the Swiss franc.”

Political risk, typically a relative constant in trading, has investors running for the doors this morning as concerns grow around Germany’s real intentions behind its short-selling ban, along with what regulations might come next. Uncertainty is being compounded by the financial overhaul debate taking place currently in DC. One comment that especially caught traders’ attentions yesterday came from Michael Novogratz, president of Fortress Investment Group, who said on CNBC, “The market is de-risking itself.” He also said, “When you want to get short there are a lot of weapons you can sell.” Glenn Dubin of Highbridge Capital added, “The sovereign debt crisis hit a wall and all bets are off,” telling CNBC. “We’re seeing massive de-risking.”

Risk indicators seem to confirm Novogratz’s and Dubin’s views showing no signs of easing this morning. LIBOR has continued to climb reaching levels not seen since last summer. At the same time AUDJPY, a popular carry trade and risk proxy, has plummeted. Until confidence returns to the market investors will continue curbing risk, and as of right now no clear short-term catalyst can be seen in the pipeline.

As of this morning, not only have US equities (as measured by the MSCI)outpaced their global counterparts, but on a year-to-date basis it’s the only index still showing gains, albeit somewhat modest. Interestingly, as of this week the spread between the MSCI US and MSCI World index reached its highest spread of the year, mostly due to losses in Latin America and emerging Europe.

Chatter’s spreading across Swiss trading floors that the country’s national bank has begun loosely managing the CHF/EUR exchange rate; preventing it to go below the 1.40 level despite prevailing trends. Traders are indicating that the Swiss National Bank have a large bid around the 1.40 level to keep the currency in check. The country’s small well integrated economy relies heavily on the banking and export sectors, which rely heavily on the stability of the Swiss Franc. While the country does not admit to currency manipulation they have stated that, “We will not be tolerant of excessive CHF appreciation”. These actions are typically what would be expected of a central bank in an emerging market or commodity exporting nations, not a G-10 economy.

European equity markets and the Eurozone currency look to be pricing in separate outlooks for the future of the Eurozone after an unprecedented rescue package. As the chart below highlights, European equities as tracked by the MSCI European index has rebounded sharply from its pre-bailout low–surely aided by the ECB’s recent actions–, while the Euro has gone on to set a new interim low. Many view the bailout as a temporary fix to a much deeper problem that can only be solved with through harsh continent wide austerity plans—if even then. If Europe manages to somehow seamlessly enact these cuts, many nations have dug themselves so deep into debt that the slightest hint of a missed number, or even worse a failed debt auction has the potential to derail the entire process; quickly leading investors away from risk. While the Euro seems to be pricing in this possibility equities do not. This analysis doesn’t even mention the impact austere policies will have on the European growth outlook, which could also weigh on equities.

Contact Me:

Michael.McDonough@fiateconomics.com
Michael is an economist/strategist who has worked from Wall Street to Hong Kong primarily focusing on the U.S. and emerging markets. He has also written several columns. More

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